The Basu Measure as an Indicator of Conditional Conservatism : Evidence from U.K. Earnings Components

Following Basu (1997), the excess of the sensitivity of accounting earnings to negative share return over its sensitivity to positive share return (the Basu coefficient) has been interpreted as an indicator of conditional accounting conservatism. Although this interpretation is supported by substantial evidence that the Basu coefficient is associated with likely demands for conservatism, concerns have arisen that it may reflect factors not directly related to conservatism, and that this may adversely affect its validity as an indicator of that phenomenon. We argue that evidence on the validity of the Basu coefficient as an indicator of conditional conservatism can be obtained by disaggregating earnings into components, classifying those components by whether or not they are likely to be affected by conditional conservatism, and examining whether the Basu coefficient arises primarily from components likely to be affected by conditional conservatism. We implement this procedure for U.K. firms reporting under FRS 3: Reporting Financial Performance from 1992 to 2004. Although a substantial proportion of the Basu coefficient emanates from cash flow from operating and investing activities (CFOI), which cannot directly reflect accounting conservatism, its incidence across other components of earnings is predominantly within those components likely to be affected by conditional conservatism. Also, although the bias documented by Patatoukas and Thomas (2009) is present in all of our aggregate earnings measures, it is heavily concentrated in the CFOI component of earnings and largely absent from components classified as likely to be affected by conditional conservatism. With the important caveat that researchers should test the robustness of their results to the exclusion of the element of the Basu coefficient due to cash flows, our findings are consistent with the conditional-conservatism interpretation of the coefficient